5 Management's Responsibility for Financial Statements

4.5. Management’s Responsibility for Financial Statements



4.5



95



Management’s Responsibility for Financial Statements



LO5 – Explain the

purpose and content of the report

that

describes

management’s

responsibility

for

financial

statements.



The final piece of informa on o en included with the annual financial

statements is a statement describing management’s responsibility for the

accurate prepara on and presenta on of financial statements. This statement underscores the division of du es involved with the publica on of financial statements. Management is responsible for preparing the financial

statements, including es mates that underlie the accoun ng numbers. An

example of an es mate is the useful life of long-lived assets in calcula ng

deprecia on.



The independent auditor is responsible for examining the financial statement informa on as prepared by management, including the reasonableness of es mates, and then expressing an opinion on their accuracy. In some cases, the auditor may assist management with aspects of financial

statement prepara on. For instance, the auditor may provide guidance on how a new accoun ng

standard will affect financial statement presenta on or other informa on disclosure. Ul mately,

however, the prepara on of financial statements is management’s responsibility.

An example of a statement describing management’s responsibility for the prepara on and presenta on of annual financial statements is shown below.

MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS



Management’s responsibility for

all aspects of financial statement

presenta on and disclosure is

expressly stated.



The

. accompanying financial statements of the company are the

responsibility of management. The financial statements were prepared by

management in accordance with accoun ng principles generally accepted

in Canada, applied on a consistent basis, and conform in all material

respects with Interna onal Accoun ng Standards. The significant

accoun ng policies, which management believes are appropriate for the

company, are described in Note 3 to the financial

.

statements.



Management’s responsibility for

es mates used and maintenance

of internal controls is acknowledged.



Management

.

is responsible for the integrity and objec vity of the financial

statements. Es mates are necessary in the prepara on of these statements

and, based on careful judgements, have been properly reflected.

Management has established systems of internal control that are designed

to provide reasonable assurance that assets are safeguarded from loss or

unauthorized use, and to produce reliable accoun ng records for the

prepara on of financial

informa

.

on.

.



96



The Classified Balance Sheet and Related Disclosures



The board of directors’ and audit

commi ee’s respec ve roles are

explained.



The

. board of directors is responsible for ensuring that management fulfils

its responsibili es for financial repor ng and internal control. The audit

commi ee of the board, which is comprised solely of directors who are not

employees of the company, is appointed by the board of directors annually.

The audit commi ee of the board meets regularly with financial

management of the company and with the shareholders’ independent

auditor to discuss internal controls, audit ma ers, including audit scope and

auditor remunera on, and financial repor ng issues. The independent

shareholders’ auditor has unrestricted access to the audit commi ee. The

audit commi ee reviews the annual financial statements and repor ng to

the board, and makes recommenda ons with respect to their acceptance.

The audit commi ee also makes recommenda ons to the board with

respect to the appointment and remunera on of the company’s auditor..



Management acknowledges its

obliga on to oversee all aspects

of the company’s opera ons in a

legal and ethical manner.



Management

.

recognizes its responsibility for conduc ng the company’s

affairs in compliance with established financial standards and applicable

laws, and maintains proper standards of conduct for its ac vi es..



The officer responsible for the

financial affairs of the company

signs and dates the statement.



(signed)

.

Bill Brown II, Chief Financial Officer

March 3,

. 2019 .



Summary of Chapter 4 Learning Objec ves

LO1 – Explain the importance of and challenges related to basic financial statement disclosure.

The objec ve of financial statements is to communicate informa on to meet the needs of external

users. In addi on to recording and repor ng verifiable financial informa on, accountants make

decisions regarding how to measure transac ons. Applying GAAP can present challenges when

judgment must be applied as in the case of cost-benefit decisions and materiality.



LO2 – Explain and prepare a classified balance sheet.

A classified balance sheet groups assets and liabili es as follows:



Summary of Chapter 4 Learning Objectives



Assets:

Current assets

Non-current assets:

• Property, plant, and equipment



97



Liabili es:

Current liabili es



Non-current or long-term liabili es



• Long-term investments

• Intangible assets



Current assets are those that are used within one year or one opera ng cycle, whichever is longer,

and include cash, accounts receivables, and supplies. Non-current assets are used beyond one

year or one opera ng cycle. There are three types of non-current assets: property, plant, and

equipment (PPE), long-term investments, and intangible assets. Long-term investments include

investments in shares and bonds. Intangible assets are rights held by the owner and do not have

a physical substance; they include copyrights, patents, franchises, and trademarks. Current liabilies must be paid within one year or one opera ng cycle, whichever is longer. Long-term liabili es

are paid beyond one year or one opera ng cycle. Income statements are also classified (discussed

in Chapter 5).



LO3 – Explain the purpose and content of notes to financial statements.

In accordance with the GAAP principle of full disclosure, relevant details not contained in the body

of financial statements are included in the accompanying notes to financial statements. Notes

would include a summary of accoun ng policies, details regarding property, plant, and equipment

assets, and specifics about liabili es such as the interest rates and repayment terms.



LO4 – Explain the purpose and content of the auditor’s report.

An audit as it relates to the auditor’s report is an external examina on of a company’s financial

statement informa on and its system of internal controls. Internal controls are the processes ins tuted by management of a company to direct, monitor, and measure the accomplishment of its

objec ves including the preven on and detec on of fraud and error. The auditor’s report provides

some assurance that the financial statements are trustworthy. In simple terms, an unqualified auditor’s report indicates that the financial statements are truthful and a qualified auditor’s report

is one that indicates the financial statements are not or may not be truthful.



98



The Classified Balance Sheet and Related Disclosures



LO5 – Explain the purpose and content of the report that describes management’s responsibility for financial statements.

This report makes a statement describing management’s responsibility for the accurate preparaon and presenta on of financial statements.



Chapter 5

Accoun ng for the Sale of Goods

...



To this point, examples of business opera ons have involved the sale of services. This chapter introduces business opera ons based on the purchase and resale of goods. For example, Canadian

Tire and Walmart each purchase and resell goods—such businesses are known as merchandisers. The accoun ng transac ons for merchandising companies differ from those of service-based

businesses. Chapter 5 covers accoun ng for transac ons of sales of goods on credit and related

cash collec ons by merchandising firms, and transac ons involving purchases and payments for

goods sold in the normal course of business ac vi es.



Chapter 5 Learning Objec ves

LO1 – Describe merchandising and explain the financial statement components of sales, cost

of goods sold, merchandise inventory, and gross profit; differen ate between the perpetual

and periodic inventory systems.

LO2 – Analyze and record purchase transac ons for a merchandiser.

LO3 – Analyze and record sales transac ons for a merchandiser.

LO4 – Record adjustments to merchandise inventory.

LO5 – Explain and prepare a classified mul ple-step income statement for a merchandiser.

LO6 – Explain the closing process for a merchandiser.

LO7 – Explain and iden fy the entries regarding purchase and sales transac ons in a periodic

inventory system.



Concept Self-Check

Use the following ques ons as a self-check while working through Chapter 5.

1. What is gross profit and how is it calculated?

2. How is a merchandiser different from a service company?

3. What is a perpetual inventory system?

4. How is the purchase of merchandise inventory on credit recorded in a perpetual system?

99



100



Accounting for the Sale of Goods



5. How is a purchase return recorded in a perpetual system?

6. What does the credit term of “1/15, n30” mean?

7. How is a purchase discount recorded in a perpetual system?

8. How is the sale of merchandise inventory on credit recorded in a perpetual system?

9. How is a sales return that is restored to inventory recorded versus a sales return that is not

restored to inventory (assuming a perpetual inventory system)?

10. What is a sales discount and how is it recorded in a perpetual inventory system?

11. Why does merchandise inventory need to be adjusted at the end of the accoun ng period

and how is this done in a perpetual inventory system?

12. What types of transac ons affect merchandise inventory in a perpetual inventory system?

13. How are the closing entries for a merchandiser using a perpetual inventory system different

than for a service company?

14. When repor ng expenses on an income statement, how is the func on of an expense reported versus the nature of an expense?

15. On a classified mul ple-step income statement, what is reported under the heading ‘Other

revenues and expenses’ and why?

16. What is the periodic inventory system?

17. How is cost of goods sold calculated under the periodic inventory system?



5.1. The Basics of Merchandising



5.1



101



The Basics of Merchandising



LO1 – Describe

merchandising

and

explain

the

financial

statement components of sales,

cost of goods

sold, merchandise inventory,

and gross profit;

differen ate

between

the

perpetual

and

periodic inventory systems.



A merchandising company, or merchandiser, differs in several basic ways

from a company that provides services. First, a merchandiser purchases

and then sells goods whereas a service company sells services. For example, a car dealership is a merchandiser that sells cars while an airline is a

service company that sells air travel. Because merchandising involves the

purchase and then the resale of goods, an expense called cost of goods

sold results. Cost of goods sold is the cost of the actual goods sold. For

example, the cost of goods sold for a car dealership would be the cost of

the cars purchased from manufacturers and then resold to customers. A

service company does not have an expense called cost of goods sold since

it does not sell goods. Because a merchandiser has cost of goods sold

expense and a service business does not, the income statement for a merchandiser includes different details. A merchandising income statement

highlights cost of goods sold by showing the difference between sales revenue and cost of goods sold called gross profit or gross margin. The basic

income statement differences between a service business and a merchandiser are illustrated in Figure 5.1.

Service Company



Merchandising Company



Revenues



Sales

Less: Cost of Goods Sold

Equals: Gross Profit



Less: Expenses



Less: Expenses



Equals: Net Income



Equals: Net Income



Figure 5.1: Differences Between the Income Statements of Service and Merchandising Companies



Assume that Excel Cars Corpora on decides to go into the business of buying used vehicles from

a supplier and reselling these to customers. If Excel purchases a vehicle for $3,000 and then sells

it for $4,000, the gross profit would be $1,000, as follows:

Sales . . . . . . . . . . . . . . . . .

Cost of Goods Sold . . . .

Gross Profit . . . . . . . .



$



4,000

3,000

$ 1,000



102



Accounting for the Sale of Goods



The word “gross” is used by accountants to indicate that other expenses incurred in running the

business must s ll be deducted from this amount before net income is calculated. In other words,

gross profit represents the amount of sales revenue that remains to pay expenses a er the cost

of the goods sold is deducted.

A gross profit percentage can be calculated to express the rela onship of gross profit to sales.

The sale of the vehicle that cost $3,000 results in a 25% gross profit percentage ($1,000/4,000).

That is, for every $1 of sales, the company has $.25 le to cover other expenses a er deduc ng

cost of goods sold. Readers of financial statements use this percentage as a means to evaluate

the performance of one company against other companies in the same industry, or in the same

company from year to year. Small fluctua ons in the gross profit percentage can have significant

effects on the financial performance of a company because the amount of sales and cost of goods

sold are o en very large in comparison to other income statement items.

Another difference between a service company and a merchandiser relates to the balance sheet.

A merchandiser purchases goods for resale. Goods held for resale by a merchandiser are called

merchandise inventory and are reported as an asset on the balance sheet. A service company

would not normally have merchandise inventory.



Inventory Systems

There are two types of ways in which inventory is managed: perpetual inventory system or periodic

inventory system. In a perpetual inventory system, the merchandise inventory account and cost

of goods sold account are updated immediately when transac ons occur. In a perpetual system,

as merchandise inventory is purchased, it is debited to the merchandise inventory account. As

inventory is sold to customers, the cost of the inventory sold is removed from the merchandise

inventory account and debited to the cost of goods sold account. A perpetual system means that

account balances are known on a real- me basis. This chapter focuses on the perpetual system.

Some businesses s ll use a periodic inventory system in which the purchase of merchandise inventory is debited to a temporary account called Purchases. At the end of the accoun ng period,

inventory is counted (known as a physical count) and the merchandise inventory account is updated and cost of goods sold is calculated. In a periodic inventory system, the real- me balances

in merchandise inventory and cost of goods sold are not known. It should be noted that even in

a perpetual system a physical count must be performed at the end of the accoun ng period to

record differences between the actual inventory on hand and the account balance. The entry to

record this difference is discussed later in this chapter. The periodic system is discussed in greater

detail in the appendix to this chapter.



An explora on is available on the Lyryx system. Log into your Lyryx course to run Using

the Informa on – Gross Profit Ra o.



5.2. The Purchase and Payment of Merchandise Inventory (Perpetual)



5.2



103



The Purchase and Payment of Merchandise Inventory (Perpetual)



LO2 – Analyze

and

record

purchase transac ons for a

merchandiser.



As introduced in Chapter 3, a company’s opera ng cycle includes purchases

on account or on credit and is highlighted in Figure 5.2.



Cash payment to supplier is made.



Inventory sold to customer.



A liability is incurred.



Accounts receivable result.

Cash is collected .

from customer.



Inventory is

purchased.



.

Time



One Opera ng Cycle



Figure 5.2: Purchase and Payment Por on of the Opera ng Cycle



Recording the Purchase of Merchandise Inventory (Perpetual)

When merchandise inventory is purchased, the cost is recorded in a Merchandise Inventory general ledger account. An account payable results when the merchandise inventory is acquired but

will not be paid in cash un l a later date. For example, recall the vehicle purchased on account by

Excel for $3,000. The journal entry and general ledger T-account effects would be as follows.

Date



General Journal

Account/Explana on

Merchandise Inventory . . . . . . . . . . . . . . . . .

Accounts Payable . . . . . . . . . . . . . . . . . . .

To record the purchase of merchandise inventory on account.



PR



Debit

3,000



Credit

3,000



In addi on to the purchase of merchandise inventory, there are other ac vi es that affect the

Merchandise Inventory account. For instance, merchandise may occasionally be returned to a

supplier or damaged in transit, or discounts may be earned for prompt cash payment. These

transac ons result in the reduc on of amounts due to the supplier and the costs of inventory. The

purchase of merchandise inventory may also involve the payment of transporta on and handling



104



Accounting for the Sale of Goods



costs. These are all costs necessary to prepare inventory for sale, and all such costs are included

in the Merchandise Inventory account. These costs are discussed in the following sec ons.



Purchase Returns and Allowances (Perpetual)

Assume that the vehicle purchased by Excel turned out to be the wrong colour. The supplier was

contacted and agreed to reduce the price by $300 to $2,700. This is an example of a purchase

returns and allowances adjustment. The amount of the allowance, or reduc on, is recorded as a

credit to the Merchandise Inventory account, as follows:

Date



General Journal

Account/Explana on

Accounts Payable . . . . . . . . . . . . . . . . . . . . . .

Merchandise Inventory . . . . . . . . . . . . . .

To record purchase allowance; incorrect

colour.



PR



Debit

300



Credit

300



Note that the cost of the vehicle has been reduced to $2,700 ($3,000 – 300) as has the amount

owing to the supplier. Again, the perpetual inventory system records changes in the Merchandise

Inventory account each me a relevant transac on occurs.



Purchase Discounts (Perpetual)

Purchase discounts affect the purchase price of merchandise if payment is made within a me

period specified in the supplier’s invoice. For example, if the terms on the $3,000 invoice for one

vehicle received by Excel indicates “1/15, n45”, this means that the $3,000 must be paid within 45

days (‘n’ = net). However, if cash payment is made by Excel within 15 days, the purchase price will

be reduced by 1%.

Assuming the amount is paid within 15 days, the supplier’s terms en tle Excel to deduct $27

[($3,000 - $300) = $2,700 x 1% = $27]. The payment to the supplier would be recorded as:

Date



General Journal

Account/Explana on

Accounts Payable . . . . . . . . . . . . . . . . . . . . . .

Merchandise Inventory . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record payment on account within the

discount period.



PR



Debit

2,700



Credit

27

2,673



The cost of the vehicle in Excel’s inventory records is now $2,673 ($3,000 – 300 – 27). If payment

is made a er the discount period, $2,700 of cash is paid and the entry would be:



5.2. The Purchase and Payment of Merchandise Inventory (Perpetual)



Date



General Journal

Account/Explana on

Accounts Payable . . . . . . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record payment of account; no purchase discount applied.



PR



Debit

2,700



105



Credit

2,700



Trade discounts are similar to purchase discounts. A supplier adver ses a list price which is the

normal selling price of its goods to merchandisers. Trade discounts are given by suppliers to merchandisers that buy a large quan ty of goods. For instance, assume a supplier offers a 10% trade

discount on purchases of 1,000 units or more where the list price is $1/unit. If Beta Merchandiser

Corp. buys 1,000 units on account, the entry in Beta’s records would be:

Date



General Journal

Account/Explana on

Merchandise Inventory . . . . . . . . . . . . . . . . .

Accounts Payable . . . . . . . . . . . . . . . . . . .

To record purchase on account; 10% trade

discount ($1,000 – 10% = $900).



PR



Debit

900



Credit

900



Note that the net amount (list price less trade discount) is recorded.



Transporta on

Costs to transport goods from the supplier to the seller must also be considered when recording

the cost of merchandise inventory. The shipping terms on the invoice iden fy the point at which

ownership of the inventory transfers from the supplier to the purchaser. When the terms are

FOB shipping point, ownership transfers at the ‘shipping point’ so the purchaser is responsible for

transporta on costs. FOB des na on indicates that ownership transfers at the ‘des na on point’

so the seller is responsible for transporta on costs. FOB is the abbrevia on for “free on board.”

Assume that Excel’s supplier sells with terms of FOB shipping point indica ng that transporta on

costs are Excel’s responsibility. If the cost of shipping is $125 and this amount was paid in cash to

the truck driver at me of delivery, the entry would be:

Date



General Journal

Account/Explana on

Merchandise Inventory . . . . . . . . . . . . . . . . .

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

To record shipping costs on inventory purchased.



PR



Debit

125



Credit

125



The cost of the vehicle in the Excel Merchandise Inventory account is now $2,798 (calculated as

$3,000 original cost - $300 allowance - $27 discount + $125 shipping). It is important to note that